1. 12 - 1 Copyright  2003 Pearson Education Canada Inc. CHAPTER 12 Audit of the Sales and Collection Cycle: Tests of Controls

2. 12 - 2 Copyright  2003 Pearson Education Canada Inc. What accounts are typically involved in the sales and collection cycle?

3. 12 - 3 Copyright  2003 Pearson Education Canada Inc. What accounts are typically involved in the sales and collection cycle? - sales - sales returns and allowances - bad debt expense - cash discounts taken - trade accounts receivable - allowance for uncollectible accounts - cash in the bank

4. 12 - 4 Copyright  2003 Pearson Education Canada Inc. What classes of transactions occur in the sales and collection cycle?

5. 12 - 5 Copyright  2003 Pearson Education Canada Inc. - sales (cash and credit) - cash receipts - sales returns and allowances - charge-off of uncollectible accounts - bad debt expense What classes of transactions occur in the sales and collection cycle?

6. 12 - 6 Copyright  2003 Pearson Education Canada Inc. What is the sequence of business functions that occurs in the sales and collection cycle?

7. 12 - 7 Copyright  2003 Pearson Education Canada Inc. What is the sequence of business functions that occurs in the sales and collection cycle? 1. A customer order is processed. Pace Company Customer Order To: Ace Company Please send us 45 gadgets on or before 10/25/04. Upon receipt, we will send payment of $3 each.

8. 12 - 8 Copyright  2003 Pearson Education Canada Inc. 2. Customer credit is approved or declined. If credit is extended to a customer, will that customer pay their balance at some point in the future? What is the sequence of business functions that occurs in the sales and collection cycle?

9. 12 - 9 Copyright  2003 Pearson Education Canada Inc. 3. The goods are shipped. Ace Company Shipping Document (Bill of Lading) 45 gadgets were shipped to Pace Company on 10/22/04. What is the sequence of business functions that occurs in the sales and collection cycle?

10. 12 - 10 Copyright  2003 Pearson Education Canada Inc. 4. The customer is billed and the sale is recorded. Ace Company Sales Invoice To: Pace Company Date: 10/22/04 Thanks for purchasing 45 gadgets. Please remit $135 ($3 each) within 30 days. What is the sequence of business functions that occurs in the sales and collection cycle?

11. 12 - 11 Copyright  2003 Pearson Education Canada Inc. sales journal description _ $$ _ Oct. 22, 2004 Pace Company 135 a/r master file customer _ $$ _ Pace Company 135 balance 135 Ace Company Sales Invoice To: Pace Company Date: 10/22/04 Thanks for purchasing 45 gadgets. Please remit $135 ($3 each) within 30 days.

12. 12 - 12 Copyright  2003 Pearson Education Canada Inc. sales journal description _ $$ _ Oct. 22, 2004 Pace Company 135 a/r master file customer _ $$ _ Pace Company 135 balance 135 Summary Sales Report This report sum- marizes all sales for a period. Accounts Receivable Trial Balance This report lists the amount owed by each customer at a point in time.

13. 12 - 13 Copyright  2003 Pearson Education Canada Inc. a/r master file customer _ $$ _ Pace Company 135 balance 135 Accounts Receivable Trial Balance This report lists the amount owed by each customer at a point in time. Ace Company Pace Company statement enclosed At month-end, customer state- ments are mailed indicating activity and amount owed. Canada 48

14. 12 - 14 Copyright  2003 Pearson Education Canada Inc. 5. Cash receipts are processed and recorded. Ace Company Pace Company Remittance Advice Ace Company Pace Company What is the sequence of business functions that occurs in the sales and collection cycle? CANADIAN BANK Canada 48

15. 12 - 15 Copyright  2003 Pearson Education Canada Inc. Ace Company Pace Company Ace Company Pace Company A remittance advice is sent to the cus- tomer with the sales invoice. It indicates the customer name, sales invoice num- ber, and amount owed. The advice is re- turned to the vendor with the customer payment. CANADIAN BANK Canada 48

16. 12 - 16 Copyright  2003 Pearson Education Canada Inc. Ace Company Pace Company Remittance Advice Ace Company Pace Company A prelisting of cash receipts is prepared each day by some- one independent of accounting and cash custody. The prelisting indicates each cash receipt. CANADIAN BANK Canada48

17. 12 - 17 Copyright  2003 Pearson Education Canada Inc. Ace Company Pace Company Remittance Advice Ace Company Pace Company a/r master file customer _ $$ _ Pace Company 135 payment-11/2 (135) balance 0 CANADIAN BANK Canada 48 cash receipts journal description _ $$ _ Nov. 2, 2004 Pace Company 135

18. 12 - 18 Copyright  2003 Pearson Education Canada Inc. CREDIT MEMO When a vendor grants credit to a customer for returned goods, a credit memo is prepared and the transac- tion is recorded in the sales returns and allowances journal.

19. 12 - 19 Copyright  2003 Pearson Education Canada Inc. AUTHORIZATION FOR UNCOLLECTIBLE ACCOUNT WRITE-OFF This form is used when a specific accounts receivable is judged uncollectible.

20. 12 - 20 Copyright  2003 Pearson Education Canada Inc. How does an auditor design tests of controls for sales?

21. 12 - 21 Copyright  2003 Pearson Education Canada Inc. How does an auditor design tests of controls and substantive tests for sales? Understand internal control as it relates to sales As discussed in chapter 9

22. 12 - 22 Copyright  2003 Pearson Education Canada Inc. How does an auditor design tests of controls and substantive tests for sales? Assess the planned control risk related to sales Understand internal control as it relates to sales

23. 12 - 23 Copyright  2003 Pearson Education Canada Inc. Assess the planned control risk related to sales In assessing control risk, the auditor should consider: Understand internal control as it relates to sales ?

24. 12 - 24 Copyright  2003 Pearson Education Canada Inc. Assess the planned control risk related to sales In assessing control risk, the auditor should consider: - adequate segregation of duties - proper authorization - adequate documents and records - use of prenumbered documents - mailing of monthly statements - internal verification procedures Understand internal control as it relates to sales

25. 12 - 25 Copyright  2003 Pearson Education Canada Inc. How does an auditor design tests of controls and substantive tests for sales? Assess the planned control risk related to sales Evaluate cost-benefit of testing controls Understand internal control as it relates to sales

26. 12 - 26 Copyright  2003 Pearson Education Canada Inc. Assess the planned control risk related to sales Evaluate cost-benefit of testing controls Will substantive tests be reduced sufficiently to justify the cost of performing tests of controls? Understand internal control as it relates to sales

27. 12 - 27 Copyright  2003 Pearson Education Canada Inc. Evaluate cost-benefit of testing controls How does an auditor design tests of controls for sales? Assess the planned control risk related to sales Design tests of controls for sales Understand internal control as it relates to sales

28. 12 - 28 Copyright  2003 Pearson Education Canada Inc. Evaluate cost-benefit of testing controls Assess the planned control risk related to sales In designing other tests of controls for sales, the auditor should consider: Do recorded sales actually exist? Understand internal control as it relates to sales Design tests of controls for sales

29. 12 - 29 Copyright  2003 Pearson Education Canada Inc. Evaluate cost-benefit of testing controls Assess the planned control risk related to sales In designing other tests of controls for sales, the auditor should consider: Are all existing sales transactions recorded? Understand internal control as it relates to sales Design tests of controls for sales

30. 12 - 30 Copyright  2003 Pearson Education Canada Inc. Evaluate cost- benefit of testing controls Assess the planned control risk related to sales In designing other tests of controls for sales, the auditor should consider: Are sales accurately recorded? Understand internal control as it relates to sales Design tests of controls for sales

31. 12 - 31 Copyright  2003 Pearson Education Canada Inc. Evaluate cost-benefit of testing controls Assess the planned control risk related to sales In designing other tests of controls for sales, the auditor should consider: Are recorded sales properly classified? Understand internal control as it relates to sales Design tests of controls for sales

32. 12 - 32 Copyright  2003 Pearson Education Canada Inc. Evaluate cost-benefit of testing controls Assess the planned control risk related to sales In designing other tests of controls for sales, the auditor should consider: Are sales recorded on the correct dates? Understand internal control as it relates to sales Design tests of controls for sales

33. 12 - 33 Copyright  2003 Pearson Education Canada Inc. Evaluate cost-benefit of testing controls Assess the planned control risk related to sales In designing othe tests of controls for sales, the auditor should consider: Are sales transactions properly included in the master file and correctly summarized? Understand internal control as it relates to sales Design tests of controls for sales

34. 12 - 34 Copyright  2003 Pearson Education Canada Inc. The auditor should also perform procedures to detect fraud related to cash receipts.

35. 12 - 35 Copyright  2003 Pearson Education Canada Inc. The auditor should also perform procedures to detect fraud related to cash receipts: Determine whether cash received was recorded.

36. 12 - 36 Copyright  2003 Pearson Education Canada Inc. ? The auditor should also perform procedures to detect fraud related to cash receipts: Prepare a proof of cash receipts.

37. 12 - 37 Copyright  2003 Pearson Education Canada Inc. The auditor should also perform procedures to detect fraud related to cash receipts: A proof of cash receipts reconciles cash receipts record- ed in the cash receipts journal with actual bank deposits.

38. 12 - 38 Copyright  2003 Pearson Education Canada Inc. ? The auditor should also perform procedures to detect fraud related to cash receipts: Test to discover lapping of accounts receivable.

39. 12 - 39 Copyright  2003 Pearson Education Canada Inc. Lapping is a fraud scheme that occurs because of inadequate segregation of duties related to mail, cash receipts, and accounting.

40. 12 - 40 Copyright  2003 Pearson Education Canada Inc. a lapping example On Monday, a cheque is received from Able Co. in payment of their a/r. The cheque is stolen by the bookkeeper! No entry is made and all evidence of the payment receipt is destroyed. A/R Able $1000 A/R Baker $1000 A/R Cain $1000 CANADIAN BANK

41. 12 - 41 Copyright  2003 Pearson Education Canada Inc. On Tuesday, a cheque is received from Baker Co. in payment of their a/r. The payment, however, is credited to Able’s account. A/R Able $1000 -1000 0 A/R Baker $1000 A/R Cain $1000 a lapping example CANADIAN BANK

42. 12 - 42 Copyright  2003 Pearson Education Canada Inc. On Wednesday, a cheque is received from Cain Co. in payment of their a/r. The payment, however, is credited to Baker’s account. A/R Able $1000 -1000 0 A/R Baker $1000 A/R Cain $1000 -1000 0 a lapping example CANADIAN BANK

43. 12 - 43 Copyright  2003 Pearson Education Canada Inc. What audit procedures may detect lapping?

44. 12 - 44 Copyright  2003 Pearson Education Canada Inc. What audit procedures may detect lapping? - a/r confirmations (disputed balances, disputed timing of payments) client’s a/r customer client Canada 48

45. 12 - 45 Copyright  2003 Pearson Education Canada Inc. What audit procedures may detect lapping? - a/r confirmations (disputed balances, disputed timing of payments) - comparison of deposit slips to cash receipts journal (different amounts, different timing)

46. 12 - 46 Copyright  2003 Pearson Education Canada Inc. Other than adequate segregation of duties, what client internal control may prevent or detect lapping?

47. 12 - 47 Copyright  2003 Pearson Education Canada Inc. Other than adequate segregation of duties, what client internal control may prevent or detect lapping? required vacations (and rotation of duties during vacations)

48. 12 - 48 Copyright  2003 Pearson Education Canada Inc. Attributes Sampling ?

49. 12 - 49 Copyright  2003 Pearson Education Canada Inc. Attributes Sampling Attributes sampling is a statistical method used to determine the proportion of population items containing a particular attribute.

50. 12 - 50 Copyright  2003 Pearson Education Canada Inc. Attributes Sampling Terms - initial sample size - based on attributes sampling tables (Table 12-7) - computed upper exception rate (CUER) - considering the extent of ex- ceptions, the worst likely population exception rate from attributes sampling tables With attribute sampling, the initial sample size and the CUER are determined by tables.

51. 12 - 51 Copyright  2003 Pearson Education Canada Inc. Attributes Sampling Sequence The attributes sampling sequence is similar to that of audit sampling. The same credit approval example will be used to illustrate attributes sampling.

52. 12 - 52 Copyright  2003 Pearson Education Canada Inc. Attributes Sampling Sequence The attributes sampling sequence is similar to that of audit sampling. The same credit approval example will be used to illustrate attributes sampling. The first six steps are the same.

53. 12 - 53 Copyright  2003 Pearson Education Canada Inc. Attributes Sampling Sequence To what degree does the auditor want to rely on controls? 7. Specify the acceptable risk of assess- ing control risk too low (ARACR). In the example, the auditors judgmentally assess the acceptable risk assessing control risk too low: ARACR = 10%

54. 12 - 54 Copyright  2003 Pearson Education Canada Inc. Attributes Sampling Sequence 8. Estimate the population exception rate (EPER) - estimate based on prior year year audit or small preliminary sample For the example: EPER = 4%

55. 12 - 55 Copyright  2003 Pearson Education Canada Inc. Attributes Sampling Sequence 9. Determine the initial sample size (SS). Table 12-7 Determining Sample Size for Attributes Sampling = 30,068 = 7% = 10% = 4% pop. TER ARACR EPER

56. 12 - 56 Copyright  2003 Pearson Education Canada Inc. Attributes Sampling Sequence 9. Determine the initial sample size (SS). Table 12-7 Determining Sample Size for Attributes Sampling sample size = 149 = 30,068 = 7% = 10% = 4% pop. TER ARACR EPER

57. 12 - 57 Copyright  2003 Pearson Education Canada Inc. Attributes Sampling Sequence 9. Determine the initial sample size (SS). What fac- tor was not considered in determining sample size? = 30,068 = 7% = 10% = 4% = 149 pop. TER ARACR EPER SS

58. 12 - 58 Copyright  2003 Pearson Education Canada Inc. Attributes Sampling Sequence 9. Determine the initial sample size (SS). What fac- tor was not considered in determining sample size? pop. = 30,068

59. 12 - 59 Copyright  2003 Pearson Education Canada Inc. SALES INVOICE 38527 Date: Acme Company Customer: 834 Reynolda Rd. Winnipeg, MB R2V 4E3 Sales Representative: Quantity Description Price total invoice amount Carrier: Credit authorization: Joe Credit Of 149 invoices examined, 7 had no credit approval. Attributes Sampling Sequence 10. Select the sample. 11. Perform the audit procedures.

60. 12 - 60 Copyright  2003 Pearson Education Canada Inc. Attributes Sampling Sequence 12. Generalize from the sample to the population. Evaluating Sample Results Using Attributes Sampling = 30,068 = 7% = 10% = 4% = 149 = 7 pop. TER ARACR EPER SS exceptions

61. 12 - 61 Copyright  2003 Pearson Education Canada Inc. Attributes Sampling Sequence Evaluating Sample Results Using Attributes Sampling 12. Generalize from the sample to the population. = 30,068 = 7% = 10% = 4% = 149 = 7 pop. TER ARACR EPER SS exceptions

62. 12 - 62 Copyright  2003 Pearson Education Canada Inc. Attributes Sampling Sequence What does this mean? Computed Upper Exception Rate (CUER) for SS of 160 (closest available) = 7.2% 12. Generalize from the sample to the population.

63. 12 - 63 Copyright  2003 Pearson Education Canada Inc. Attributes Sampling Sequence There is a 10% risk (ARACR) that the true exception rate > 7.2% Computed Upper Exception Rate (CUER) for SS of 160 (closest available) = 7.2% 12. Generalize from the sample to the population.

64. 12 - 64 Copyright  2003 Pearson Education Canada Inc. Attributes Sampling Sequence 13. Analyze the exceptions. 14. Decide on the acceptability of the population. The population is not acceptable; the controls regarding the indication of credit approval on sales invoices are not satisfactory. The last two steps in the sequence are the same as those for audit sam- pling. Those steps lead to the same conclusion for the example.